Decoder Model Portfolio Update: Hot Money Chokehold
In this week's model portfolio update:
"Hot money" is an age-old problem for emerging-market countries, and stock and commodity prices too. Its presence, and sudden withdrawal, can wreak havoc on all manner of assets. Roughly speaking, hot money is financial capital that flows quickly between financial institutions, asset classes, or even countries, always seeking to maximize the highest available return.
When hot money floods in quickly, it tends to drive asset prices sharply higher via the phenomenon of too much money (liquidity) chasing too few goods (assets). It can also fuel wild economic booms by lowering the cost of money (making loans cheap) to the point of mass overbuilding, grossly inflated property values, and so on.
Hot money can also have surprising knock-on effects, like when surplus capital from German banks helped fuel giant property bubbles in Spain and Ireland in the mid-2000s. As a surplus country with large volumes of export savings it could not deploy at home, Germany had a large volume of capital in its banks sitting around — until it flowed into the smaller economies of Spain and Ireland, fueling a boom that later became an incredibly destructive bust.
When hot money leaves suddenly, it can create price implosions or even a full-blown currency crisis, as with Thailand in the Asian currency crisis of the mid-1990s. At its peak Thailand was covered in construction cranes, its runaway building boom fueled by dollar-denominated loans (borrowed money that had to be paid back in dollars). When the loans started going bad because the construction projects made no sense, the hot money that had rushed into Thailand rushed back out again, creating a liquidity vacuum and ultimately forcing a currency collapse.
Hot money can also create serious problems in stocks and commodities, as shown via the dot-com bubble that burst in March 2000 or the oil price running above $140 per barrel in the summer of 2008. This happens when investors extrapolate future gains into the present, behaving as if 20 years' worth of profits will somehow be packed into the next two, or when institutional investors see rising prices as a valid economic signal rather than a byproduct of their own mass buying.
We started reflecting on this relative to recent strange behavior in the gold market, where Chinese speculators are now front and center: Per the Financial Times, activity on the Shanghai Futures Exchange (SHFE) has exploded, with some China-based futures trading firms taking multi-billion-dollar positions. This helps explain why gold had a sudden surge in recent weeks that otherwise didn't make sense given the array of factors working against inflation-sensitive assets right now: Rising interest rates, a strengthening dollar, the Federal Reserve transitioning to hawkish against the backdrop of a strong U.S. economy, and so on.
We are happy to play on the same side as other speculators and "go with the flow" of hot money, but only when that flow is aligned with general conditions. When that flow is against general conditions, the odds increase of sudden reversal and a potential price implosion or collapse. Against a backdrop of conditions that are near-term unfavorable for gold, we would not want to be on the same side as a Chinese futures firm leveraged up to its eyeballs while facing a multi-billion-dollar margin call.
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